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CIS. Monetary Policy
and Financial Markets

By Ann-Marie Meulendyke
Federal Reserve Bank of New York


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CIS. Monetary Policy
and Financial Markets

By Ann-Marie Meulendyke
Federal Reserve Bank of Hew York
Federal Reserve Bank of New York
33 Liberty Street
New York, N.Y. 10045

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U.S. MONETARY POLICY AND FINANCIAL MARKETS
LIBRARY OF CONGRESS CATALOG CARD NUMBER 82-71781
FEDERAL RESERVE BANK OF NEW YORK
Designed by Howard Mont Associates Inc.


Forward
From time to time officials at the Federal Reserve Bank of New
York have prepared special works sharing with economists, market
participants, and others their own personal perspective on the monetary policy process. Of particular note in this regard was Robert
Roosa's 1956 essay entitled Federal Reserve Operations in the
Money and Government Securities Markets. In 1982, Paul Meek, in
U.S. Monetary Policy and Financial Markets, described a policy setting process that had changed considerably from that described by
Bob Roosa. The nature and functioning of financial markets continued to change in subsequent years, and the conduct of monetary
policy has evolved as well. Since Paul Meek's book was published,
the procedures of policy implementation that he described as "new"
have been transformed again.
In this volume, Ann-Marie Meulendyke, a manager and senior
economist assigned to the Bank's domestic trading desk, has offered
her personal perspective on the monetary policy process and financial markets of the 1980s. The new essay describes the recent evolution of Federal Reserve procedures and places them in the context
of the longer historical sweep of Federal Reserve policy. This new
essay should benefit students of the subject well into the 1990s.
E. Gerald Corrigan
President
Federal Reserve Bank of New York

New York City
December 1989

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Acknowledgements
Paul Meek wrote the first edition of U.S. Monetary Policy and
Financial Markets, published in 1982. With its detailed descriptions
of the policy process at the Federal Reserve, it proved to be a valuable
and widely used resource for students and financial market participants in the CInited States and abroad. To date, the Federal Reserve
Bank of New York has distributed around 55,000 copies. The book
has also been translated into Japanese, Korean, and Portuguese.
During the years since the book was published, Federal Reserve
policy procedures and U.S. financial markets and institutions have
undergone substantial change. In order to maintain the usefulness of
Paul Meek's volume, it seemed appropriate to offer a new version of
the work. What has emerged is essentially a new book on similar
themes rather than simply an update of the earlier book. Nonetheless,
in doing the writing, I have been guided where possible by the structure
of Paul Meek's book and have made significant use of material from
it. I am deeply indebted to Paul not only for paving the way with his
book but also for encouraging me in my work during the years that
we both worked in the Open Market area at the New York Fed.
Special mention must go to Donald Vangel of the Open Market
Function and to Christine Cumming of the International Capital

Markets Group, who were primarily responsible for the preparation of
Chapters 3 and 9, respectively. Don brought to the topic his knowledge
of bank management and regulation and described some of the many
changes that have been taking place in the banking industry in recent
years. Chris drew upon her knowledge of international economic relationships to write about the international transmission of monetary
policy, expanding on a topic that received only brief attention in 1982.
This book also owes a great deal to many other colleagues in the
Federal Reserve System. Members of the Open Market Function
patiently read drafts, and offered valuable suggestions. In addition,
they graciously took over some of my normal responsibilities to
give me extra time to work on the book. Many thanks to Peter
Sternlight, Joan Lovett, Robert Dabbs, Kenneth Guentner, Sandra
Krieger, Cheryl Edwards, and Jeremy Gluck, as well as Don Vangel.
Jeremy, along with Lawrence Aiken, Deborah Perelmuter, and Mary
Vitiello, deserves thanks for assisting in the preparation of the material on financial markets in Chapter 4.
A number of members of the Bank's Research Department read
and made useful suggestions on various parts of the book, particularly
the discussion of monetary policy transmission in Chapters 8 and 9.
My thanks to Richard Davis, Gikas Hardouvelis, Bruce Kasman,
Charles Pigott, Lawrence Radecki, George Sofianos, Charles Steindel,


and John Wenninger. John Partlan and Judy Cohen of the monetary
and reserve projections unit helped with Chapter 6. Margaret Greene
and Willene Johnson of the Foreign Exchange Department reviewed
sections in Chapters 5, 6, and 9 on foreign exchange intervention.
At the Board of Governors, David Lindsey and Brian Madigan
read the chapters and offered helpful comments. Robert Hetzel at
the Richmond Federal Reserve Bank and Leland Crabbe at the
Board drew upon their knowledge of Federal Reserve history to

enhance Chapter 2.
Several people outside the Federal Reserve deserve special thanks
for their careful reading of the manuscript: Dana Johnson of the First
National Bank of Chicago, David Jones of Aubrey G. Lanston, and
Jeffrey Leeds of Chemical Bank. Lawrence DiTore of Fulton Prebon
provided insights into the functioning of the Federal funds market.
Several people who once worked in the Open Market area of the
Federal Reserve contributed oral history. They included Edward
Geng, John Larkin, Paul Meek, Robert Roosa, and Robert Stone.
Research assistance, editing, and typing are invaluable to any
such endeavor. Debra Chrapaty provided primary research assistance, spending long arduous hours reading historical documents
on microfilm. Two summer interns, Francisco Gonzales and
Jennifer Hof, provided additional research assistance. Robert
Hellmann provided research assistance on Chapter 9. Valerie
LaPorte patiently edited the book, always keeping me attentive to
the reader's desire for clarity. Peter Bakstansky, John Casson, and
Dan Rosen of the Public Information Department assisted with a
range of editorial and production jobs. Last but by no means least,
my secretary, Evelyn Schustack, earns many thanks for her patient
typing and retyping of drafts. Renee Legette also assisted with the
typing. While all of the people named helped to make the book
much more accurate and readable than it might otherwise have
been, I bear the responsibility for the remaining errors.
Ann-Marie Meulendyke
New York
December, 1989

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CI.S. Monetary Policy
and Financial Markets

Monetary Policy and the U.S. Economy
Money and the Economy
Money and the Policy Process
Box: Money and Credit Definitions
The Tools of Policy
Plan of the Book
1. Evolution of Federal Reserve Procedures
2. The Depository Institutions
3. The Role of the Financial Markets
4. The Policy Process
5. The Economic Impact
6. International Dimensions of Monetary Policy
7. Reflections on the 1980s

18

48

3
4
5
7
10
11
11
12

13
14
16
17

The Federal Reserve and U.S. Monetary Policy: A Short History
The Beginning of the Federal Reserve and
World War I: 1914 to 1919
Adapting to a Changed Environment in the 1920s
Major Contraction: 1929 to 1933
Active Policy making by the Adminstration: 1933 to 1939
Accommodating War Finance in the 1940s
Resumption of an Active Monetary Policy
in the 1950s and 1960s
Targeting Money Growth and
the Federal Funds Rate: 1970 to 1979
Targeting Money and Nonborrowed
Reserves from 1979 to 1982
Monetary and Economic Objectives with Borrowed
Reserve Targets: 1983 to the Present

47

The Role of Depository Institutions
The Business of Banking
Banking Risks
Strategic Considerations
Tactical Considerations

49

54
59
60

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18
20
25
28
30
32
38
43


Financial Intermediaries and the Financial Markets
Bank-related Financial Markets
1. The Federal Funds Market
2. The Market for Certificates of Deposit
3. Bankers' Acceptances
Box: Financing through Bankers' Acceptances
4. The Eurodollar Market
5. The Interest Rate Swap
Nonbank Financial Instruments
1. The U.S. Treasury Debt Market
a. The primary market
b. The secondary market
c. Derivative products

2. The Market for Federally Sponsored Agency Securities
3. Corporate Dept Instruments
a. Commercial paper
b. Corporate bonds
4. Municipal Securities

The Financial Markets
71
72
72
75
78
80
82
84
85
85
85
87
92
94
98
98
100
103

66

5
The FOMC Meeting: Developing a Policy Directive

Preparation
106
The Meeting
108
1. Reports of the Managers
109
a. The report on international developments
109
b. The report on domestic operations
111
2. Sizing Up the Economic Situation
112
a. The board staff presentation
112
b. Discussion of the economy
113
3. The Longer Run Monetary Targets
113
a. Presentation
113
b. Developing annual ranges
114
4. Short-Run Policy Alternatives
116
a. Presentation
116
5. Preparing the Directive
118
a. Discussion of the specifications
118

b. Writing the directive
119
Box: Operating Paragraphs from FOMC
Domestic Policy Directives
120
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124

148

The Trading Desk: Formulating Policy Guidelines
Formulation and Operation of the Reserve Objective
1. Creating the Nonborrowed Reserve Objective
2. Adjustment by the Banking System to Policy Actions
Box A: Description of Reserve Measures
Total Reserves:
Required Reserves:
Excess Reserves:
Borrowed Reserves:
Nonborrowed Reserves:
Estimating Reserve Availability
Box B: Forecasting Factors Affecting Reserves
Currency:
Treasury Cash Balances:
Federal Reserve Float:

Foreign Exchange Intervention:
Foreign Central Bank Transactions:
Other Factors:

124
124
126
127
127
129
132
135
136
140
141
141
141
143
144
146
147

The Conduct of Open Market Operations
The Strategy of Reserve Management
Tools of Open Market Operations
1. Outright Operations
2. Temporary Transactions
A Day at the Trading Desk
1. Daily Dealer Meetings
2. The Treasury Call

3. Formulating the Day's Program
4. The Conference Call
5. Executing the Daily Program
Communications Within the System
Adjunct Desk Responsibilities

148
150
151
155
157
158
159
162
168
170
173
174

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8
Evolving Views of Policy Transmission
Monetary Policy and Yield Curves
Responses to Operating Procedures
Policy's Effect on the Economic Sectors
1. The Household Sector
2. The Business Sector

3. State and Local Governments
4. The U.S. Government
The Role of the Fed Watchers
1. Projecting and Interpreting the
Behavior of Reserves and Desk Activity
2. Budgetary and Economic Forecasting

Responses to Federal Reserve Policy
179
185
188
190
191
193
194
195
197
198
200

International Aspects of Monetary Policy and Financial Markets
Key Changes in the International Financial System
202
International Channels of Transmission
of U.S. Monetary Policy
204
1. The Impact of Expectations and Financial Asset Prices
204
2. International Effects of Changes in
U.S. Real Activity and Prices

210
International Influences on U.S. Monetary Policy
212
The Impact of Changes in International Financial Markets
215
The Principal International Short-Term Markets
216
1. The Eurodollar Deposit Market
216
2. Mondeposit Money Markets
217
International Money Markets and U.S. Monetary Aggregates 218
The Principal International Long-Term Markets
219
1. The Eurobond Market
219
2. U.S. Treasuries and Other Government Bonds
220
Conclusion
221
Box: Foreign Exchange Market Intervention
222

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178

202


w
Experiences of the 1980s

226


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Monetary Policy and
the U.S. Economy
Few components of economic policymaking are as important to
the nation's economic well-being as monetary policy. This book
offers the reader information on monetary policy from the vantage
point of the Federal Reserve's domestic trading desk, the area
responsible for carrying out most monetary policy actions. It
emphasizes the process of formulating and implementing policy.
As the central bank for the United States, the Federal Reserve
has been entrusted by the Congress with the responsibility for conducting monetary policy. Monetary policy is concerned with the
terms and conditions under which money and credit are provided
to the economy. Money comprises currency and coin issued by the
Federal Reserve or the U.S. Treasury and various kinds of deposits
at commercial banks and other depository institutions. Credit
encompasses loans made by depository institutions and by other
types of financial or nonfinancial entities and includes loans evidenced by debt instruments such as notes or bonds.
Under the Full Employment and Balanced Growth Act of 1978,
usually referred to as the Humphrey-Hawkins Act for its primary
sponsors, the Federal Reserve must establish annual growth targets
for the monetary aggregates and explain how these targets relate to
goals for economic activity, employment, and prices. Monetary policy is carried out by the Federal Reserve through its regulations and

techniques for the issuance of currency and its provision of reserve
balances. The behavior of reserves can in turn influence deposit
behavior since some classes of deposits are partially backed by
them.7 The Federal Reserve can influence the rates and other conditions of credit extension by its monetary policy actions, although
it cannot directly control the quantity of credit or its price.2
In addition to having a mandate to carry out monetary policy in
a way that promotes sustainable economic expansion and reasonable price stability, the Federal Reserve also has responsibilities for
promoting the smooth functioning of the nation's financial system.
It tries to accommodate the substantial short-run variations in the
1 Currency outside the Federal Reserve, including cash in bank vaults, and total reserve
holdings at the Federal Reserve constitute the monetary base, sometimes called "highpowered money" or "outside money." The monetary base is often singled out as a potential target variable. At least conceptually, the central bank has the power to control the
issue of both components of the monetary base. Traditionally, the monetary base served
as backing for other forms of money, although currently some of the items contained in
the broader forms of money have little or no such direct backing.
2 The Federal Reserve does not set targets for credit growth, although it does announce
annual monitoring ranges for a particular indicator of total credit behavior called nonfinancial debt, defined in Box A.


demand for money and credit that inevitably arise in a complex
market economy. The Federal Reserve monitors a wide variety of
financial variables and responds when they seem to indicate that
credit conditions are out of step with System policy goals.
Determining the appropriate policy stance and balancing longand short-run objectives in the execution of policy have proved to
be very challenging. Decisions must be made as events are unfolding on the basis of data whose full significance is not yet clear. The
policy actions themselves become part of the dynamic economic
processes and may have effects that extend over considerable
periods of time.
The next three sections of this chapter provide information on
the role of money in the economy and examine the tools of policy.
These sections serve as background for the discussion of the financial system and policy process in later chapters.

Money and the Economy
Since money represents generalized purchasing power, it ought
to be reasonably well linked over time with the nominal value of the
total spending and output of goods and services in the nation's
economic system. Individuals and companies choose to hold
money because its use greatly simplifies a wide range of economic
transactions. On the other hand, they limit their money balances
because holding money has costs in the form of forgone opportunities for alternative investments in goods, services, or financial
instruments. The amount of money that is consistent with the goals
for prices and output depends upon the customs, practices, regulations, and political environment of the economy. If these are stable, the relationship between money and economic activity will
tend to be stable as well. Monetary growth in excess of that needed
to support sustainable growth in economic activity will be associated with generalized price increases.
The amount of money that people wish to hold will not, however, always bear a constant relationship to the level of economic
activity. The demand for money will also depend upon expectations of future price changes. For instance, if rapid inflation is
expected, people will seek to minimize holdings of those forms of
money that do not provide a return sufficient to offset the expected loss of purchasing power caused by rising prices. On the other
hand, if prices are expected to be steady, people will hold more
money because of its convenience in conducting transactions.
Another factor influencing the demand for money is the ease of

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conversion between money and those nonmoney instruments that
provide a greater return than money.
As underlying economic conditions or expectations shift, the
behavior of money will also change. Usually these changes will be
so gradual that they will not seriously interfere with short-term policymaking, but on occasion they may be rapid enough to complicate policy choices. Even when the underlying conditions are
stable, demands for money will vary considerably from day to day

and week to week in response to seasonal and institutional payment conventions. The Federal Reserve attempts to sort out these
effects and to accommodate the short-run changes in money
demand without compromising its ability to influence money over
time to achieve long-term goals.
One factor complicating the process of determining the appropriate behavior of money is the absence of a good match between the
conceptual definition of money—given in textbooks as a medium of
exchange, a standard of value, a standard of deferred payments, and
a store of wealth—and the actual financial instruments that exist in
the United States. 3 Because financial instruments have varying
degrees of "moneyness," the Federal Reserve has set forth several
definitions of money, listed in Box A. The narrow measure of money,
Ml, comes closest to conforming to all the criteria of the textbook definition, but it omits items that have most of the characteristics of
money and are often better stores of value than Ml. The broader measures, M2 and M3, capture some of these close substitutes for Ml.
Money and the Policy Process
In the policy process, "money" has traditionally served as an
intermediate target or indicator, standing between the Federal
Reserve's ultimate goals of sustainable economic growth with price
stability and the operating targets used for day-to-day policy
implementation. Money occupies this position because its behavior is related both to the ultimate policy goals of the Federal
Reserve, which cannot be controlled directly, and to the potential
policy tools over which "the Fed" has direct control. Until the
1980s, empirical data supported the view that Ml growth was a
reasonably predictable leading determinant of nominal economic
activity. The Federal Reserve had only an imprecise ability to control Ml, but over several quarters, it could come close to achieving

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3 See, for instance, Thomas Mayer, James S. Duesenberry, and Robert Z. Aliber, Money,
Banking, and the Economy, 3d ed. (New York: W.W. Norton and Company, 1987), p. 5.



Box: Money and Credit Definitions
Ml consists of currency in circulation outside of the Treasury,
Federal Reserve Banks, and depository institutions; travelers checks;
demand deposits at all commercial banks other than those due to
depository institutions, the U.S. government, and foreign banks and
official institutions, less cash items in the process of collection and
Federal Reserve float; other checkable deposits (OCD), including
negotiable order of withdrawal (NOW) and automatic transfer service
(ATS) accounts at depository institutions; credit union share draft
accounts; and demand deposits at thrift institutions.
M2 consists of Ml plus overnight and continuing contract repurchase agreements (RPs) issued by all commercial banks; overnight
Eurodollars issued to (J.S. residents by foreign branches of U.S.
banks worldwide; money market deposit accounts (MMDAs); savings and time deposits (including retail RPs) in amounts of less than
$100,000; and all balances in general purpose and broker-dealer
money market mutual funds. M2 excludes individual retirement
accounts (IRAs) and Keogh (self-employed retirement) balances at
depository institutions and in money market funds. Also excluded
are all balances held by U.S. commercial banks, money market
funds (general purpose and broker-dealer), foreign governments,
foreign commercial banks, and the U.S. government.
M3 consists of M2 plus time deposits and term RP liabilities in
amounts of $100,000 or more issued by commercial banks and
thrift institutions; term Eurodollars held by U.S. residents at foreign
branches of U.S. banks worldwide and at all banking offices in the
United Kingdom and Canada; and all balances in institution-only
money market mutual funds. M3 excludes amounts held by depository institutions, the U.S. government, money market funds, and
foreign banks and official institutions. Also excluded is the estimated amount of overnight RPs and Eurodollars held by institution-only
money market mutual funds.

Total nonfinancial debt is defined as outstanding credit market debt
of the U.S. government, state and local governments, and private
domestic nonfinancial sectors. Private debt includes corporate bonds,
mortgages, consumer credit (including bank loans), other bank loans,
commercial paper, bankers' acceptances, and other debt instruments.
The Federal Reserve Board's flow of funds accounts are the source of
domestic nonfinancial debt data expressed as monthly averages.

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a desired rate of money growth by adjusting either the levels of the
banks7 reserve balances or short-term interest rates. Similarly, the
response of nominal gross national product (GNP) to changes in
Ml showed seasonal and cyclical variation, but it was also reasonably predictable over the long run.
In the 1970s, the Federal Reserve sought to take advantage of
the empirical regularities and to control money growth in order to
reduce inflation. For most of the decade, it adjusted reserves to
influence the interest rate on interbank transfers of reserves—the
Federal funds rate—as a means of changing money growth. However, persistent overshooting of the money targets and other forces
had pushed prices upward until, by 1979, inflation had reached
wholly unacceptable levels. Eager to halt and wind down the inflationary process of the 1970s, the Federal Reserve adopted a
reserve targeting approach to money control in October of that
year. The technique met with considerable success if judged by its
effect on average money growth and its impact on inflation. By
1982, the economy was in a deep recession and considerable

progress had been made in overcoming inflation. Nonetheless, Ml
was growing rapidly by recent standards. It appeared that the previous relationships between Ml growth and nominal economic
activity were not standing up well. Consequently, the techniques of
policy implementation were modified late in 1982 in a way that
deemphasized the money growth targets, especially those for Ml.
The causes of the shifts in money demand have gradually
become better understood, although even at this writing many
questions remain. For about three decades, the relationship
between money and income had been reasonably stable and predictable. Nominal GNP had grown faster than Ml, so the income
velocity of Ml, or its rate of turnover per income-generating transaction, had risen an average of 3 percent a year. But a series of factors combined to make people less reluctant to hold Ml balances,
and income velocity declined during the first half of the 1980s (see
Chart 1, page 7). The spread of interest-bearing NOW accounts
made individuals more inclined to hold some of their savings in
transactions form. Lower inflation made the loss in purchasing
power from holding money balances smaller, an outcome which
made holding money a more attractive option. When interest rates
began falling, forgone interest from holding money balances also
declined. Although the demand for money rose on average, it also
became more sensitive to short-run interest rate movements. With
components of Ml paying rates that were above zero but slow to

6


Chart 1 Trend of M1 Velocity
Velocity (log scale)
10

9
8


1953

'56

'59

'62

'65

'68

71

74

77

'80

'83

'86

'89

Velocity trend from 1953.1 to 1979.4 was 3.2 percent per year

change, there were large swings in the relative relationship between market rates and rates on money balances. The trend velocities of M2 and M3 did not shift as much, but for M2, the variability

of velocity increased (see Charts 2 and 3, page 8).
While reducing their reliance on the behavior of the monetary
aggregates as policy indicators, policymakers placed greater
emphasis on measures that might be termed intermediate indicators. These included commodity prices and monthly statistics on
employment, production, and trade. Such measures are not directly controllable but, taken together, they ought to suggest at least
the direction in which policy instruments should be adjusted to
achieve the ultimate policy goals.
The Tools of Policy

The Federal Reserve traditionally had three primary instruments of monetary policy: reserve requirements, the discount
rate, and direct open market purchases and sales of U.S. government securities. Using these tools, the Federal Reserve could
affect the cost and availability of reserves to commercial banks
and other depository institutions.

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Chart 2 Trend of M2 Velocity
Velocity (log scale)
2

1.6

1.4
1953

'56

'59


'62

'65

'68

'71

'74

'77

'80

'83

'86

'89

'65

'68

'71

'74

'77


'80

'83

'86

'89

Velocity trend from 1953.1 to 1979.4 was -0.03 percent per year

Chart 3 Trend of M3 Velocity
Velocity (log scale)
2

1953

'56

'59

'62

Velocity trend from 1953.1 to 1979.4 was -0.07 percent per year

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8



Reserve requirements play a role in establishing the banks'
demand for reserves and help determine the effects of the other
monetary tools on bank behavior. Commercial banks and other
financial institutions accepting deposits against which payments
can be made must maintain reserves in the form of cash held in
their vaults or deposits at Federal Reserve Banks. The existence of
reserve requirements underlies the relationship between the volume of reserves and the transaction deposit component of money.
The Depository Institutions Deregulation and Monetary Control
Act of 1980 (MCA) imposed uniform reserve requirements across
all depository institutions holding transactions deposits. It also
specified a schedule for implementing the new reserve requirements. Although the MCA gave the Board of Governors of the
Federal Reserve System authority to alter reserve requirements
without regard to the designated phase-in schedule if necessary for
monetary policy, the provision was not used during the phase-in
period. Indeed, changes in reserve requirements for the express
purpose of influencing the behavior of money or credit have not
been made since 1979.
The discount window provides depository institutions with the
means to borrow reserves from the Federal Reserve at a specified
rate. The Federal Reserve, relying on administrative procedures,
limits access to the facility by restricting frequency and amount of
use. Although the volume of borrowing is usually modest, the
terms for gaining access to the discount window are an important
part of the policy implementation process. The limitations on borrowing contribute to the seemingly contradictory result that
increases in the amount of reserves in the banking system, when
provided by the discount window, act to restrict reserve availability by putting banks under pressure to find other sources of
reserves to repay the loans.
Changes in either the discount rate or the rules and guidelines
for access to the facility can affect the costs to depository institutions of obtaining reserves to support deposit and credit growth.

Discount rate changes are initiated by the regional Reserve Banks'
boards of directors and are subject to final review and determination by the Board of Governors in Washington. The response of
depository institutions to the settings of the discount rate affects
short-term interest rates. Banks respond both to the rate itself and
to the implicit or explicit message about policy contained in the
announcement. These relationships make discount policy an integral part of monetary policy. Changes in Federal Reserve policies

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toward use of the window have been rare. Normally they have consisted of temporary reductions on restrictions because of an
unusual strain on the banking system.
Open market operations are the primary tool used for regulating
the pace at which reserves are supplied to the banking system.
Open market operations consist of purchases and sales by the
Federal Reserve of financial instruments, usually securities issued
by the U.S. Treasury. Open market operations are carried out by
the domestic trading desk of the Federal Reserve Bank of New York
under directions from the Federal Reserve's principal monetary
policy making unit, the Federal Open Market Committee (FOMC).
The transactions are arranged through firms that act as dealers,
routinely buying and selling Treasury debt. Purchases by the desk
add reserves while sales drain reserves from the banking system.
Such purchases and sales may be made outright or they may be
made under a temporary arrangement in which the transaction is
reversed after a specified number of days.
Reserve requirements, discount policy, and open market operations can be used separately or in combination. Even though
they are under different jurisdictions within the Federal Reserve
System, their use can be coordinated to meet the needs of a particular situation. Of the three tools, open market operations provide the greatest flexibility and are the most actively employed

tool. Nevertheless, the FOMC must take account of the settings
of the other instruments in making its choices for open market
policy. The FOMC meets regularly and monitors a variety of
monetary and economic indicators in order to choose an appropriate policy mix.
Plan of the Book

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The structure of the book largely follows that of its predecessor,
Paul Meek's 1982 volume on CI.S. monetary policy. This section
previews the principal topics in the sequence in which they are
treated in the book. Although a more detailed picture will emerge
in the following pages, it may be helpful to note here certain broad
divisions in the subject matter. Chapters 2-4 cover various aspects
of the institutional setting for U.S. monetary policy. They are followed by three chapters describing the policy process itself, then
two exploring the ways that policy affects the domestic and international economy. Chapter 10 assesses the record of monetary
policy in the 1980s and the economic and financial conditions that
accompanied it.

10


1. Evolution of Federal Reserve Procedures

The history of the policy process, the subject of Chapter 2,
reveals how the Federal Reserve has responded to new problems
and changing conditions by significantly modifying its primary
goals and the techniques for achieving them. Indeed, since the
Federal Reserve's beginnings in 1914, both Congress and the

Federal Reserve have substantially revised their views of the
Federal Reserve's mandate. In the early days, the gold standard
was expected to take care of stabilizing the price level. The Federal
Reserve saw its role as providing reserves to accommodate routine
variations in the needs for credit to finance trade and as providing
currency to avoid financial panics. But the experience of the Great
Depression altered priorities, and in the years following the Second
World War, the policymakers considered economic stabilization a
primary goal. Then, during the 1970s, the goal of price stability
acquired increased importance as inflation worsened.
The tools of policy evolved over time as well. In the System's
early years, discount window loans were the predominant means
of short-term adjustments to reserves while secular changes in
money and credit stemmed primarily from changes in monetary
gold. In more recent times, both secular growth in money and
accommodation of short-term variation in money and credit
demands have been provided through open market transactions,
primarily in U.S. Treasury securities.
2. The Depository Institutions
Monetary policy reflects continuing interactions among the
Federal Reserve, financial institutions, the financial markets, and
members of the nonbank public who deposit and borrow funds.
The functioning of the depository institutions, described in Chapter
3, plays a role in transmitting the Federal Reserve's policy impulses to the economy.
Each depository institution considers many factors in managing
its balance sheet. The balance sheet compares assets, which
encompass loans and investments, with capital and liabilities, the
latter consisting of deposits and other types of debt. When a depository institution makes loans or investments, it must weigh the
interest to be earned against risks incurred, and it must take
account of the cost of capital requirements on the asset acquired

and the return on the capital that the assets should generate. In
attracting deposit liabilities, it needs to take account of the direct

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and indirect costs involved, including paying interest and account
management expenditures as well as any reserve requirements on
those deposits. If the maturities of the assets and liabilities differ, it
must consider the implications of changes in interest rates over
their lives. In recent years, the introduction of new regulations and
the greatly increased degree of interest rate volatility have complicated the tasks of asset and liability management.
While depository institutions set conditions for accepting
deposits and making loans, their customers choose how to
respond to the rates and terms established by the institutions.
Customer behavior in turn affects the mix of deposits and the
amount of lending that takes place. Customers choose among
deposit categories on the basis of interest rates and other features,
but they also act according to their incomes and assets, the timing
of their payments and receipts, and the ease of conversion between
money and near-money instruments. The amount of credit actually extended depends on the level of economic activity and perceived gains from investments, in addition to the interest rates
charged by depository institutions on their loans compared with
the cost of alternative sources of credit.
3. The Role of the Financial Markets
The effects of monetary policy actions are not limited to the
depository institutions. Indeed, as described in Chapter 4, governments at various levels, quasi-governmental agencies, private corporations, and individuals engage in extensive direct financial
market borrowing and lending. The United States has vast financial

markets where debt and equity are created and redistributed.
These markets are competitive and serve to direct capital to the
users with the most urgent demands.
Depository institutions, other financial firms, nonfinancial businesses, and governments all place funds in, or borrow from, the
money market—the term used for financial markets specializing in
instruments maturing in a year or less—to bridge differences in
timing between receipts and payments. They also use the market
to defer long-term borrowing or lending to a more propitious time.
They use the longer term capital markets to borrow for investment
purposes. Lenders may place funds for a long period, or they may
purchase a security with the intention of selling it when cash is
needed in what is called the secondary market.
The existence of active secondary markets facilitates transfers
of existing debt instruments before maturity and enables the New

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York Fed's domestic trading desk to conduct open market operations efficiently. Open market operations take place in two segments of the markets: that for CI.S. Treasury securities and that for
temporary purchases and sales of government securities, referred
to as repurchase agreements (RPs) and matched sale-purchase
agreements (MSPs). The Federal funds market allows depository
institutions to exchange reserve balances at the Federal Reserve
among themselves, an arrangement which promotes the efficient
use of reserves and the building of a large volume of deposits and
credit on a relatively small reserve base. The Federal funds rate,
the rate for overnight exchanges of Federal funds, responds to

reserve availability and is regarded by money market participants
and observers as a useful, although not always reliable, indicator
of the stance of Federal Reserve policy.
4. The Policy Process
The formulation and execution of monetary policy, reviewed in
Chapters 5-7, occur in several stages. The process originates with
the actions of the FOMC, which typically meets eight times a year
in Washington, D.C. At these meetings, the 7 governors and the 12
presidents of the regional Reserve Banks evaluate the economic
outlook and develop monetary policy. The Chairman of the Board
of Governors presides over the meetings; the permanent voting
members of the Committee include the governors and the president of the New York Federal Reserve Bank. Four other Reserve
Bank presidents serve as voting members on a rotating basis for
one-year terms. At every FOMC meeting, instructions are adopted
and sent to the domestic trading desk at the New York Federal
Reserve. This "directive" indicates whether the Committee desires
to increase, maintain, or decrease the degree of reserve pressure.
Reserve pressure is produced by forcing depository institutions to
borrow rationed credit from the discount window. The directive
may also indicate that potential developments—for example, in the
monetary aggregates, economic activity, or prices—could call for
adjustments to the degree of reserve pressure during the period
between meetings.
The objectives set by the FOMC for the growth of various monetary and credit measures during the current calendar year are
reported by the Chairman every February to the banking committees of the Congress as required by the Humphrey-Hawkins Act. In
July, the Chairman reports any revisions in that year's objectives,
along with preliminary goals for the subsequent year.

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The trading desk at the New York Fed provides reserves to the
banking system in a manner designed to be consistent with the
FOMCs desired level of discount window borrowing and sensitive to
the implications for short-term rates. In implementing the Committee's directive, the desk purchases or sells U.S. Treasury debt instruments to bring reserves into line with established objectives.
Changes in the policy stance of the FOMC usually are quickly
detected by banks and other financial market participants. When
the degree of pressure on bank reserve positions is increased,
banks will have to satisfy a larger share of their reserve needs at the
discount window. Since their access to the discount window is limited, they will bid up the Federal funds rate. Over time, depository
institutions will respond to the reserve restrictions by shifting the
rate structure of their assets and liabilities. Their actions help to
lower financial asset prices, raising market rates and providing
incentives for other economic participants to reduce their holdings
of money and their use of credit. Gradually, growth of money balances and credit should slow. At some point, the pace of real economic activity and of inflation will abate. Conversely, when pressure
on bank reserves is eased, the Federal funds rate falls, and over
time banks will be encouraged to acquire more assets. The resultant
portfolio adjustments will eventually work to spur monetary growth,
increase credit availability, and quicken economic activity.
5. The Economic Impact

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What, then, are the channels through which monetary policy
impulses are transmitted to the economy? This question, addressed
in Chapter 8, is difficult to answer because lags and feedback

effects hamper efforts to trace all connections. Furthermore, a
complex economy operating in a wider world context will not
always react in a predictable way to a particular policy initiative.
Nonetheless, much has been learned over the years. Individuals and
businesses make decisions to buy or sell goods and services and to
borrow or lend on the basis of current and expected values of
income, interest rates, and prices. In addition, they respond to the
ease or difficulty of obtaining credit. It is the job of the Federal
Reserve to analyze these influences and to formulate a monetary
policy that appropriately responds to them.
Analysts of the monetary transmission process differ in the
importance they attach to the various channels. Some economists,
often referred to as Keynesians, emphasize the influence of interest
rates on economic decisions. They contend that a stimulative mon-

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etary policy arises when sufficient reserves are provided to reduce
interest rates. Lower rates are viewed as stimulating borrowing for
investment and consumption expenditures. These expenditures in
turn will encourage an increase in output. If output rises to the point
where it is straining the productive capacity of the economy, then
competition for scarce resources will result in higher prices.
Other economists, often called quantity theorists or monetarists,
have emphasized the importance of adjustments in money supply
and demand in determining the state of the economy and the
behavior of the price level. They expect that money demand will
be reasonably stable over meaningful periods of time while recognizing that demand can be subject to short-run variations and that
shifts can arise out of institutional change. The quantity theorists

include interest rates, income, and prices in the list of factors determining the demand for money. They maintain that money demand
is fairly predictable over time, but they acknowledge that economic
activity and prices may be slow to respond to monetary growth
impulses since people do not fully adjust their spending patterns
as soon as their money balances change.
The impact of expectations on economic decisions has received
increased attention in the models of both groups of economists in
recent years. Expectations formulation has become an important
component of the analysis of the monetary transmission mechanism. In particular, much interest has centered on expectations
about inflation and their effect on the interpretation of interest
rates. Judging whether interest rates are high or low requires
knowing people's expectations about the degree to which inflation
will erode the purchasing power of money during the term the
funds are borrowed or lent.
Many analysts examine monetary policy transmission in the
context of the business cycle. In recent decades, the Federal
Reserve has attempted to take account of lags in the policy process and to anticipate economic responses in its use of policy to
counter cyclical developments. The idea is to take restrictive policy steps before the economy overheats and inflation follows, and
to initiate easing steps before a recession occurs. In practice, however, imperfect forecasts have meant that the Fed cannot always
correctly anticipate the best time for a shift in policy. Still, once an
economic turn has been recognized, prompt responses can mitigate extremes of business fluctuations.
Various sectors of the economy will respond differently over the
business cycle to monetary policy influences, in part because

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interest rate changes have different implications for them. For
instance, consumers as a group are net creditors, while the federal
government is generally a net debtor. Moreover, within each sector
and income group, debt or credit positions will vary considerably.
Finally, the communication of economic and financial developments can be a factor in policy transmission. The speed with which
information is disseminated has increased markedly in recent
years. As prices and interest rates have become volatile over the
last two decades, firms that have particular needs to predict and
understand interest rate developments expanded the resources
they devote to monitoring the economy and Federal Reserve policy in order to avoid adverse surprises.
6. International Dimensions of Monetary Policy
In the United States, monetary policy is still largely conducted
with an eye toward domestic economic conditions and still based
on domestic monetary and financial aggregates. Nevertheless, it
has become increasingly apparent that the United States is far
from being a closed economy. As Chapter 9 shows, U.S. monetary
policy can have a significant impact on other countries' economies, and developments abroad can affect the U.S. economy to
a substantial degree. Moreover, foreigners use U.S. dollars as a
transactions medium, a store of value, and to establish value in
long-term contracts. In many dollar transactions, U.S. residents
are not participants, and the transactions do not enter into any U.S.
economic or financial statistics.
The increased awareness that the United States is an open economy that cannot operate in isolation from the rest of the world
reflects the rapid expansion of international trade and financial
transactions in the postwar period. As foreign trade has grown,
both absolutely and as a share of GNP, exchange rates have come
to have substantial bearing on U.S. income and production levels
and on the rate of inflation in the United States. Increased trade has
been accompanied by enlarged international capital flows, which
were facilitated by the dismantling of capital controls by many

nations in the 1970s. Looked at in isolation, the floating exchange
rates that replaced pegged rates in the early 1970s increased the
opportunities for each country to pursue its own monetary policy
goals independent of the actions of other nations. Nevertheless,
increased trade and financial flows worked to make exchange rate
changes—including those that stem from monetary policy actions
—important policy considerations. They also elevated the impor-

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